Chas Craig, BridgeTower Media Newswires
In The Alchemy of Finance George Soros wrote, “Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values.” Said another way, in certain instances, instead of serving as a measurement of economic value, security prices can create self-fulfilling prophecies via feedback loops.
In the following paragraphs, we will explore three reflexivity examples: (1) A company reliant upon external sources of growth capital; (2) A company wishing to have the ability to use its stock as a currency for future acquisitions; and (3) A high-growth, cash-burning enterprise using company shares in lieu of cash as a primary means for compensating employees.
For the first type, consider a company relying on capital markets for fresh cash to invest in growth capital expenditures. If fundamentals in the company’s industry weaken, its stock price will likely follow suit, making the sale of new shares more costly via a higher level of share dilution to get the same dollar amount. This higher cost of capital results in fewer growth projects exceeding the required hurdle rate. As a result, growth prospects for the company’s cash flow via new projects dims, leading to further pressure on the company’s share price.
This vicious feedback loop can go on and on until all future growth prospects are taken out of the company’s valuation. If the firm carried too much debt, it could end with a bankruptcy filing. However, it is important to point out that this sort of feedback loop can go the other way too, becoming a virtuous cycle. This sort of reflexivity has had important implications for many participants in the oil and gas industry in recent years.
Next, consider Bank OZK, the management of which has historically made shareholder value creating acquisitions and hopes to execute more M&A during the next industry downturn when they expect their bank’s superior profitability, credit quality and financial position will be better reflected in its relative valuation. While OZK has historically traded at a meaningful valuation premium to its peers, it now trades at a sizable relative discount. As such, the wisdom of management’s refusal to repurchase shares out of an abundance of caution despite publicly stating they think their company’s valuation is unjustifiably depressed is confounding considering its very high capitalization ratios.
If OZK’s share price is in fact trading at a significant discount to intrinsic business value, repurchasing shares is value enhancing to the remaining shareholders, which should eventually be reflected by a higher share price. Beyond this direct impact, as opposed to continuing to build excess capital, a higher valuation could give OZK’s management more firepower to pursue accretive future M&A because the bank’s shares would serve as a more valuable currency, improving the bank’s fundamental prospects via a reflexive relationship with its share price.
Moving on, attracting and retaining high quality labor is an important fundamental driver for almost any company, and this might be especially true for high-growth technology firms which often operate at cash flow deficits during periods of heavy investment. Given the negative cash flow position of these companies, they often compensate employees with hefty doses of equity compensation. If the share price meaningfully declines for one reason or another, it has a very real impact on the company’s ability to attract and retain talent, impacting fundamentals.
We’ll close with a quote from Seth Klarman’s Margin of Safety: “Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important.”
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
